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7/12/2007

Earnings Gains Critical For Stock Success

Today Investor's Business Daily in its Investor's Corner section has article about importance of earnings. One of the key to finding a stock likely to move up is to find first or second significant earnings acceleration is stocks earnings cycle.

Earnings strength is the grand poobah of all fundamentals.

In IBD studies of the greatest market winners, earnings per share growth stands out as the single most important factor shared by the best stocks before they made their big advances.

Earnings are the pennies of each revenue dollar not consumed by a company's wages, taxes and other costs.

Strong players don't just grow sales. They also improve margins, cash flow and return on equity. These improvements help to boost earnings.

Behind every major move is a earnings acceleration. The earning season provides you with the ability to identify such stocks. Stocks react vigorously to earnings acceleration. After a few quarters of earnings acceleration, every one notices it and the reaction is more muted as the earnings get discounted.While there is a vast effort by many speculators to anticipate such earnings acceleration and take positions in anticipation, even if you react to earnings and enter after the earnings announcement, you still can catch bulk of the move.Typically first earnings acceleration is followed by more earnings acceleration or the improved earnings continues. The structural factors which contribute to earnings acceleration do not disappear in one quarter. That is why earnings trends persist and price trends persist.If you go to Mark Minervini's site and look at his SEPA model, he illustrates this fact with a picture.

Some days back I talked about the importance of overall contextual framework for any strategy. Once the conceptual framework is understood it is easier to implement a strategy. Much of the work on my earnings based modelling has been based on a book by Richard Bernstein.Merrill Lynch quantitative strategist Richard Bernstein in his book Style Investing: Unique Insight Into Equity Management offers a very useful conceptual framework for understanding the role of earnings and earnings expectations in stocks price growth.Bernstein's earnings expectations model compares earnings expectations of a typical company on a clock face. When a company is at its pinnacle in growth term it is at 12.00 midnight. In his book he offers a strategy to identify stocks early enough in their growth cycle. The idea is to find growth stocks early enough but not to overstay the party. That is why the name Cinderella strategy- you should not overstay the growth party and must leave the party before midnight.The strategy basically offers a choice of value investing or growth investing based on how early you identify earnings potential of a stock.

12 to 312 o’clock: The company’s earnings are high and expectations are also very high1 o’clock: Torpedo is a negative earning surprise3 o’clock: Analysts revise earnings estimates downward. Growth investors abandon the stock.3 to 6 4 o’clock: Earnings expectations continue to fall dramatically.6 o’clock: At some stage earnings expectations reach their low point. At this point most of the bad news is priced in. Expectations are at lowest level.6 to 9This is where value investors focus. Value investors want to buy stocks neglected by market but which have the potential to surprise on earnings front. They want to buy it before the earning surprise. One of the risk of value approach is if you buy too early, you have to wait a long time.7 o’clock: Stock has a positive earnings surprise. If it is a genuine turnaround there will be more surprises down the line.9 o’clock: Market starts to recognise the stock and its earning potential.9 to 12This is where primarily growth investors focus. They want companies that have exhibited consistent earnings growth over several quarters. They pay premium for such stocks as the stock has already moved from low expectations to high. The value investors pass on these stocks to growth investors during this transition phase. The risk of growth investing is overstaying the party beyond midnight.11 o’clock: Everyone becomes aware of the company.12 o’clock: Earnings and earnings expectations reach peak.

The CANSLIM strategy primarily operates in the 9 to 12 quadrant. That is one of the reason many of the stocks on IBD 100 can break down also after appearing in the list. Earnings lead breakouts operates primarily in the 6 to 9 quadrant. Building a mix of earnings based strategies in the 6 to 12'o clock time frame gives you best of both worlds.

Earnings acceleration and neglect are two essential elements to finding the big movers. Every earnings season these two things come together to create mis priced opportunities. Even if you follow the IBD 70 plus strategy, you must dig deeper to see if this is recent earnings acceleration or not. Those are the stocks to prefer over other 70 plus EPS candidates. The trick is to buy as close to first earnings acceleration as possible.

Once in a while you get a stock which will continue to have very good earnings growth for very long period of time like 2-4 years, those are the stocks which go on to make 10 times plus moves. Invariably, if you look at those stocks, they would be neglected stock before their first earnings acceleration. Familiar and popular stock can seldom give you major gains.

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